The Almighty Dollar-Cost Averaging

At Hudson Oak Wealth, one of our core investment management beliefs is that market-timing strategies are not appropriate if our goal is long-term investment success. While some situations may cause minor tactical shifts to be appropriate, ongoing timing of market movements is not part of a repeatable and consistent process that leads to long-term investment success. Think of the most famous and esteemed investors of the last 100 years - almost none of them are known for their market-timing acumen or get-rich-quick strategies. They are revered for their diligence and fortitude to stick with time-tested strategies over long-periods of time while taking complex matters and making them simple. One such technique that fits this description is Dollar-Cost Averaging (DCA).

In simple terms, Dollar-Cost Averaging is the process by which an investor invests a pre-determined amount (or percentage in some cases) within an investment portfolio at regularly recurring frequencies over a period of time. The reason for doing this is by investing an equal amount over time, an investor is able to help neutralize some of the unpredictable risks of the investment universe. Committing to this approach will mitigate investor biases and short-term reactionary behaviors to temporary downturns in broader investment markets. A DCA strategy can help neutralize some of the volatile impacts of short-term market movements as you are increasing the likelihood of buying in at several different market prices.

In fact, using a DCA strategy during a market downturn is often a great example of the tried-and-true investment philosophy of “buy-low” being applied in practice. The primary benefit of using DCA when markets are down is that an investor is able to purchase more shares of the same security than they would have been able to at a higher price when valuations are high and investor sentiment is sometimes too strong, causing a bubble. If the security is one the investor believes in from a long-term perspective, all that has occurred with a DCA strategy is that the security was effectively purchased on sale. Take for example if you are to commit to investing $1,000 per month and the price the first month is $20/share you are buying 50 shares of the investment. If prices drop to $10/share you would then be able to buy 100 shares with the same investment.

However, just as DCA can be a great strategy when markets have temporarily turned sour, some of the opposite is true when markets are continuously advancing. While an investor is able to take part in the euphoria or positivity of a bull market, they are actually acquiring less of each security through a DCA strategy. This is not necessarily a bad outcome because developing good investing habits and simply avoiding market timing altogether is a positive behavior for most. Interestingly enough, from a behavioral standpoint it feels much easier to DCA when prices are overvalued because the general investor sentiment is positive due to strong recent market performance. In fact, the best bargains occur when prices are depressed and it is more difficult for investors to stick with their DCA strategy.

In some regards, the use of an employee-sponsored retirement plan such as a 401(k) is a form of a DCA strategy. Rather than receive additional cash flow via payroll, an investor has money automatically dedicated to be continuously invested into the market at regularly reocurring time intervals. The most common instance in which DCA makes the most practical sense is following a large windfall of cash flow, such as a large performance bonus, a liquidity event surrounding equity compensation or business sales, or sudden wealth following a divorce or inheritance.

An example of DCA at work can be beneficial to see the power the technique can offer. Assume Jane Doe recently received a $1,500,000 inheritance outright from a wealthy relative. She received $1,500,000 in a mix of cash and risky securities that do not fit her financial or investment planning goals. Thanks to the recent step-up in basis that the securities received, Jane is able to sell the securities at little to no tax cost. Once she has $1,500,000 in cash there are several courses of action she can take next. For example purposes, lets assume her two options are as follows:

  1. Invest all $1,500,000 immediately.

  2. Invest $1,500,000 in equal amounts over a pre-established period of time (DCA).

Assume that in either case Jane were to invest in the same diversified portfolio. Over the 6 Quarters the following occurred for her given portfolio.

Dollar Cost Averaging.PNG

If Jane invests all $1,500,000 into a diversified portfolio immediately in 2019 and the portfolio experiences a decline of over the next 6 quarters before bottoming at 20% below the peak, she will have approximately $1,200,000 at that point. If she invested $250,000 each quarter for 6 quarters she will have certainly been able to invest several tranches of her portfolio at cheaper prices than she would have by investing it all as a single lump-sum. Therefore, Jane would have acquired more shares while the market was approaching a bottom, meaning more upside when the markets improved. Simply by using a DCA strategy, Jane has reduced her volatility and rather than suffering a 20% decline she may have only incurred an overall decrease of less than 6%. Jane’s situation is just an example intended for educational purposes and should not be used as personalized planning or investment advice. A similarly opposite result could occur if markets rose by 20% over the same period. The point is, volatility has been relatively reduced not just through a diversified investment approach but in how and when the investments were made.

DCA is a great first approach for almost anyone looking to grow their portfolio over time while trying to minimize downside risk - whether a 401(k) contributor or someone with newly found wealth who wants to intelligently participate in the market but not unnecessarily risk their recent influx of cash. While no honest professional will claim they can determine with absolute certainty the future direction of markets in the near-term, the evidence suggests that a disciplined approach such as DCA can result in positive long-term investment results. In the end, it is again, more about developing good investment behavior and habits more than chasing superior short-term returns. DCA, by it’s very nature, forces this positive investor behavior.

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